High-risk, high-reward or innovative protection for your moves in the market – Contracts for Difference can be both.
It is a popular misconception that contracts for differences (CFDs) are the preserve of the high-flying, risk-taking, gun-slinging day trader – using them to jump in and out of BP 30 times a day for hopefully a couple of points each time. While this is certainly one way they can be used, there is no law that says to trade CFDs you should be in and out within a matter of hours or less.
With the margin facility that CFDs offer, and the ability to profit from markets falling as well as rising, you can use CFDs to spread your risk over a number of shares – strong and weak – and operate like a mini hedge fund. In this way you use margin to help spread your risk across a number of trades, rather than going all or nothing on just one. A few examples will hopefully help to illustrate the principle.
Let’s assume our trader has £10,000 in a CFD account. Her broker lets her leverage this up by a factor of 10 – so she can have up to £100,000 – worth of open positions. The first thing to consider is the most important four-letter word in investing or trading – risk.
The sad reality is that most new entrants to the trading arena spend too much time wondering how many bedrooms there mansion should have when they hit that big winning trade to even give risk a second thought. If you ignore risk then one day (usually not too far down the line) it will come back and bite you, to remind you why you should have thought of it in the first place.
Managing risk
But our trader is very level-headed and wants to stay in the game for a long time. She recognises that most sensible approaches to risk management recommend only risking 1% to 3% of your pot on any one trade. She decides to have a risk on any one trade of 2% – if any of her decisions go wrong it is only going to cost her £200 in losses (2% of £10,000 trading capital). This does not mean she will jump out of a trade if it goes 2% against her. There are plenty of shares that will move more than 2% a day and, if she is exiting as soon as that is hit, the only one getting rich is the broker on commissions (where applicable). The 2% rule governs how many shares she lets herself buy or sell short as the examples clarify.
Our trader is undecided on market direction and feels there could be some sideways-moving markets ahead – some shares will rise, some will fall but the overall results will be not much progress. So she decides to build up a portfolio of long trades (buying shares with CFDs to profit from them going up) and short trades (selling shares she does not own via CFDs to profit from them falling, and buy them back cheaper). Her fundamental and technical analysis highlights a couple of prospects. First FTSE 250 transport company Go-Ahead Group (GOG) has been moving higher since March last year, the fundamentals look good and the share recently hit fresh highs – which she considers a positive sign. She thinks there is more potential to come in the weeks ahead and decides her stop loss will go in at £12.90, just below the recent support on the charts – the next thing she has to figure out is how many to buy.
The share is currently trading at £13.79 and her sensible approach to risk is only going to allow her to lose £200 on any one trade. So, if she buys at £13.79, and jumps out at £12.90 if the price trend reverses, her risk per share is 89p (£13.79 less £12.90). When deciding how many to buy it is a simple calculation – her risk is 89p a share, she is allowed to lose £200, therefore she should buy 224 shares (£200/.89). She logs on to her CFD broker and places the trade, buying 224 shares at £13.79 – a value of £3,088. But of course, because she is trading with CFDs her broker does not require the full amount and allocates 10% of this (£309) from her account as margin for the trade. If she had done this with a traditional stockbroker, already almost one-third of her available capital is tied up – not so with CFDs. Because she is particularly disciplined she places a stop loss order with her CFD company to sell out if the price falls to £12.90.
With the margin facility that CFDs offer, and the ability to profit from markets falling as well as rising, you can use CFDs to spread your risk over a number of shares – strong and weak.
Because she thinks it is going to be a choppy few months in the market she wants to find a company to short sell and profit from a drop in the price. One of the beauties of CFDs is you are not just tied to the UK markets – so she looks across the Pond to US stock Best Buy (BBY:US). This is an electronic retailer and with concerns over the retail boom running out she feels this has potential to drop from its currently lofty $59 mark. Since she does not have a crystal ball she decides that if the share price rallies to $63 she will close her short and take the loss because that would suggest she is wrong. Again, all she has to do is figure out how many to short-sell – remember she is happy to risk £200 on each trade. Her risk is $4 per share ($63 – $59) which translates to around £2.20 at current exchange rates. A quick calculation (£200/2.20) tells her she can short sell 90 shares to stay within her accepted risk parameters so she gets on and does the trade. She short-sells 90 shares at $59, a total of $5310. Again her broker does not want the full amount, but will allocate 10% of the total from her account – in this case around £295 at current exchange rates.
She now has around £600 of her account tied up in these two trades (£300 from the Go Ahead long, £295 from the Best Buy short) but has plenty of margin left to fund other opportunities. If these two trades go wrong and she is stopped out, she will only lose £400 (plus commissions if applicable).
There are some additional points to bear in mind when it comes to margin. When going long using margin (that is profiting from a share price rising) there is a daily interest charge because in effect you are borrowing money to do the trade. This is usually slightly above the base rate and if you hold CFDs past approximately six weeks what you save on stamp duty you pay in interest. Obviously if the position is going in your favour, and margin has let you take advantage of more opportunities than would be usual, this may be of small concern to most people, but has been mentioned for the sake of completeness. When short, you actually receive interest (slightly less than base rate) so in theory you could run a short for as long as you want without incurring a financing charge.
Winning Margin
The great thing about CFDs for a lot of people is the margin facility. Our trader above has opened two trades and still has plenty of ammunition left to capitalise on any other opportunities. This is an example of margin being used sensibly rather than in an all-or-nothing fashion. The balance between longs and shorts can make particular sense in sideways-moving markets where strong shares edge higher and weak shares slide. It is not going to make ridiculously high returns but is a way of being almost market-neutral and drastically reducing large day-to-day swings in the trader’s profit-and-loss account. Obviously, if market direction is clearly up, then a trader would not want to be going short everything in sight, but would use CFDs to build up long positions and thus open up the potential for more profits than buying the shares outright. To sound like a broken record – there is no Holy Grail but the flexibility of going long or short, and the sensible use of margin means CFDs should be considered by active investors full stop – they are not just for the day traders.
